Question 6.14: Rusli Ltd provides a car valet service for car hire business...
Rusli Ltd provides a car valet service for car hire businesses when their cars are returned from hire. Details of the service costs are as follows:
| Per | car | |
| £ | £ | |
| Car valet charge | 20 | |
| Less Variable costs | 14 | |
| Fixed costs | \underline{4} | \underline{18} |
| Profit | \underline{2} |
Sales revenue is £10 million a year and is all on credit. The average credit period taken by Rusli Ltd’s customers is 45 days, although the terms of credit require payment within 30 days. Bad debts are currently £100,000 a year. Trade receivables are financed by a bank overdraft with an interest cost of 10 per cent a year.
The credit control department of Rusli Ltd believes it can eliminate bad debts and can reduce the average credit period to 30 days if new credit control procedures are implemented. These procedures will cost £50,000 a year and are likely to result in a reduction in sales of 5 per cent a year.
Should the business implement the new credit control procedures?
(Hint: To answer this activity it is useful to compare the current cost of trade credit with the costs under the proposed approach.)
The current cost of trade credit is:
| £ | |
| Bad debts | 100,000 |
| Overdraft interest ((£10m × 45/365) × 10%) | \underline{123,288} |
| \underline{223,288} |
The annual cost of trade credit under the new policy will be:
| £ | |
| Overdraft interest ((95% × £10m) × (30/365) × 10%) | 78,082 |
| Cost of control procedures | 50,000 |
| Net cost of lost sales ((£10m/£20 × 5%) × (20 − 14*)) | \underline{150,000} |
| \underline{278,082} |
The above figures reveal that the business will be worse off if the new policies are adopted.